Chapter 30

1. Chapter 30 Managing Aggregate Demand: Monetary Policy Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it meant. But they knew that it was an act of extreme wisdom. JOHN KENNETH GALBRAITH

2. Monetary Policy • Monetary policy • Federal Reserve System • Change • Interest rates • Money supply • Aimed - affect the economy

3. Money and Income: Difference • Money • At one point in time • E.g.: money stock (M1) • Income • Over a period of time • E.g.: nominal GDP per year

4. The Federal Reserve System • The Federal Reserve System “The Fed” • U.S. central bank • Bank for banks • Origins • 1873-1907: four severe banking panics • 12 central banks • Corporations • Stockholders: member banks • Profits – to U.S. Treasury

5. The Federal Reserve System • Board of Governors (7 members) • Appointed by U.S. President • Chairman (4-year term) • Advice & consent of Senate • 14-year term • The Fed • Independent • Monetary policy

6. The Federal Reserve System • Federal Open Market Committee (FOMC) • 12 members • 7 governors of the Fed • President of the Fed – New York • 4 (of 11) district banks presidents • Short-term interest rates • Size of U.S. money supply

7. The Federal Reserve System • Central bank independence • Make decisions • Without political interference • Help control inflation

8. Implementing Monetary Policy • Open-market operations • Fed’s purchase / sale • Government securities • Transactions: Open market • The Fed – lower interest rates • Purchase: Treasury bills (T-bills) • Pays: newly created bank reserves

9. Implementing Monetary Policy • Market for bank reserves • Supply curve • Federal Reserve policy • Upward-sloping • Demand curve • Banks – required to hold reserves • Reflects • Demand for transaction deposits – banks • Depends on real GDP & price level • Downward-sloping

10. Figure 1 The market for bank reserves S D For given Fed policy E Interest Rate For given Y and P D S Quantity of Bank Reserves

11. Implementing Monetary Policy • Market for bank reserves • Federal funds rate • Interest rate • Borrow/lend reserves among banks • The Fed – lower federal funds rate • Purchase T-bills • Additional reserves to market • Supply curve – shift outward • Lower interest rates • More bank reserves

12. Figure 2 The effects of an open-market purchase S0 S1 D E A Interest Rate D S0 S1 Quantity of Bank Reserves

13. Implementing Monetary Policy • Federal Reserve • Wants lower interest rates • Purchases U.S. government securities • In the open market • Pays - creating new bank reserves • Required reserve – no change • Actual reserves – increased • Excess reserves • Multiple expansion process

14. Table 1 Effects of an open-market purchase of securities on the balance sheets of banks and the Fed Reserves +$100 million Bank Reserves +$100 million U.S. government securities +$100 million U.S. government securities -$100 million Bank gets Reserves Addendum: Changes in Reserves Actual Reserves +$100 million Required Reserves No Change Excess Reserves +$100 million Fed gets securities

15. Implementing Monetary Policy • Fluctuations • People - hold cash • Banks - hold excess reserves • Federal Reserve • Wants to increase interest rates • Sells U.S. government securities • In the open market • Banks pay: reserves (deposits at the Fed) • Multiple contraction process

16. Implementing Monetary Policy • Expansionary monetary policy • Fed buys T-bills • T-bills prices – increase • Demand – unchanged • Supply (available to private investors) • Inward shift • Interest rates – fall

17. Figure 3 Open-market purchases and treasury bill prices S1 S0 D A B P1 Price of a Treasury Bill P0 S1 D S0 Quantity of Treasury Bills

18. Implementing Monetary Policy • Open-market purchase • Treasury bills - by the Fed • Raises the money supply • Drives up T-bill prices • Pushes interest rates down • Open-market sale - T- bills - by the Fed • Reduces the money supply • Lowers T-bill prices • Raises interest rates

19. Other Methods of Monetary Control • The Fed – lender of last resort • Lending to banks • Interest rate: discount rate • Bank – increase excess reserves • Discount rate – decrease • Banks – borrow more • Increase reserves

20. Table 2 Balance sheet changes for borrowing from the Fed Reserves +$5 million Loan from Fed +$5 million Loan to Bank +$5 million Bank Reserves +$5 million Addendum: Changes in Reserves Actual Reserves +$5 million Required Reserves No Change Excess Reserves +$5 million Bank borrows $5 million And the proceeds are credited to its reserve account

21. Other Methods of Monetary Control • Minimum required reserve ratio • Decrease • Increase excess reserves • Money expansion • Lower interest rates • Increase • Decrease excess reserves • Money contraction • Higher interest rates • 10% since 1992

22. How Monetary Policy Works • Expansionary monetary policy • Open-market purchase • Lower interest rates • Contractionary monetary policy • Open-market sale • Raise interest rates

23. Figure 4 The effects of monetary policy on interest rates S0 S0 S2 S1 D D E E A B Interest Rate Interest Rate D D S2 S1 S0 S0 Bank Reserves Bank Reserves (b) Contractionary Monetary Policy (a) Expansionary Monetary Policy

24. How Monetary Policy Works • Sensitive to monetary policy • Investment • Net exports • Contractionary monetary policy • Higher interest rates (r) • Lower investment spending (I) • Lower total spending [C+I+G+(X-IM)] • Lower expenditure schedule • Lower aggregate demand

25. Figure 5 The effect of interest rates on total expenditure 45° C+I+G+(X-IM) (lower interest rate) C+I+G+(X-IM) (higher interest rate) C+I+G+(X-IM) Real Expenditure Real GDP

26. How Monetary Policy Works • Expansionary monetary policy • Lower interest rates (r) • Encourage investment (I) • Higher total spending • Higher expenditure schedule • Multiplier effect on aggregate demand

27. Figure 6 The effect of expansionary monetary policy on total expenditure 45° C+I1+G+(X-IM) C+I0+G+(X-IM) E1 E0 Real Expenditure 0 5,500 7,000 6,000 6,500 Real GDP

28. How Monetary Policy Works • Effect of monetary policy • On aggregate demand • Depends on • Sensitivity of interest rates • To open-market operations • Responsiveness of investment spending • To interest rate • Size of basic expenditure multiplier

29. Money & Price Level in Keynesian Model • Expansionary monetary policy • Increases aggregate quantity demanded • At any given price level • Causes some inflation • Depends on slope of aggregate supply curve

30. Figure 7 Inflationary effects of expansionary monetary policy D1 D0 S E B $500 billion Price Level 100 103 S D0 D1 0 6,000 6,400 Real GDP

31. Money & Price Level in Keynesian Model • Aggregate demand – slopes downward • Higher price level • Reduce purchasing power • Depress exports, Stimulate imports • Increase quantity of bank deposits demanded • Demand curve (bank reserves) – shift outward • Increase federal funds rate • Higher interest rate • Discourage investment • Lower aggregate quantity demanded

32. Figure 8 The effect of a higher price level on the market for bank reserves S D0 D1 E1 E0 Interest Rate Effect of a higher P S D0 D1 Bank Reserves